Bigamy, grave robbing and passing false cheques are pretty much the only crimes that Ben Bernanke and the Federal Reserve have not been accused of in the past few weeks.

Since the US central bank launched its $600bn round of asset purchases at the start of November, its critics have not hesitated to accuse it of recklessness, incompetence and conspiracy to devalue the dollar, often in vitriolic terms.

Wolfgang Schäuble, the German finance minister, called the Fed “clueless” and accused it of steering “the dollar exchange rate artificially lower”. Republicans in Congress decried a Fed policy that, through some voodoo, they think will not only fail to stimulate the economy but will also create inflation.

Last week’s Fed “data dump” – revealing details of 21,000 transactions with banks during the financial crisis from 2007-2009 – has prompted accusations that the Fed bailed out foreigners or lent against dodgy collateral.

There are legitimate criticisms of the Fed, but many of these attacks could be turned back on the attackers.

Start with the dollar. All else being equal, some fall in the exchange rate is the inevitable consequence of the easing of monetary policy, always and everywhere.

Yet since the start of November the euro has depreciated by about 5 per cent against the dollar, prompted in large part by Germany’s insistence on talking about future mechanisms to restructure eurozone sovereign debt in the middle of a eurozone sovereign debt crisis.

Then there is the political criticism that the Fed’s asset purchases will lead to runaway inflation. Central bank purchases of government bonds can do this – but only in cases when politicians run a persistent fiscal deficit and then force the central bank to finance it.

“The Federal Reserve hasn’t gotten the message. Printing money is no substitute for sound fiscal policy,” said Mike Pence, a leading Republican in the House of Representatives, last month.

Quite right, the Fed might say, now how about that sound fiscal policy? Even as members of Congress attack the Fed, they are moving towards an extension of Bush-era tax cuts on all income levels that will add about $3,700bn to the deficit if continued over the next 10 years.

The official deficit commission run by Erskine Bowles and Alan Simpson came up with a plan that, like it or not, would deal with the deficit. It did not win sufficient bipartisan support. Congress is adding more than its share to long-term inflation risks in the US.

Finally, consider the fallout from the Fed’s data release last week. “After years of stonewalling by the Fed, the American people are finally learning the incredible and jaw-dropping details of the Fed’s multi-trillion-dollar bail-out of Wall Street and corporate America,” said Bernie Sanders, an independent senator from Vermont.

Two of the biggest criticisms are that the Fed lent against the questionable collateral of low-rated debt and that much of its help went to foreign banks. There is no doubt that the Fed took risks.

If Congress had not come through with the $700bn troubled asset relief programme then the results for the central bank would have been unpleasant.

But the point of the Fed’s lending was to provide liquidity to markets that had frozen up. It could not have done this if it had only been willing to lend against Treasury bonds, which were almost the only asset that remained liquid throughout the crisis without Fed help.

Heavy use of Fed facilities by foreign banks reflects the global role of the dollar and the intense demand for US currency during the crisis. Denying liquidity to overseas central banks and to the New York branches of foreign banks would have been a quick way to end that global role. It might also have forced foreigners to default on their obligations to American banks.

At least the Fed’s rescue worked: it was paid back in full, with interest, on all its emergency loans and prevented a devastating financial collapse. Would that Ireland – where bank losses have overwhelmed the government’s finances – could say the same.

Friday, December 3, 2010

Republicans are pressuring the Federal Reserve to shift away from the dual mandate of price and output stability and focus primarily on price stability. They argue as the Fed has focused on creating more jobs it has come at the possibility of higher inflation.

Most of the recent criticism has come after the announcement for a second round of quantitative easing. I am a bit baffled by the recent push for a single mandate of price stability. If the Federal Reserve had a single mandate of price stability, would monetary policy be any different from today. Bernanke, perhaps more than anyone else, understands the risk an economy faces in the event of a debt-deflation spiral. His research has been instrumental in helping policymakers understand the risks associated with a large decline in prices. Following the housing crisis, the U.S. consumer faced record levels of debt. If prices decline, debt increases in real terms. If the economy would have entered a period of 2-3% of deflation, the real interest rate would have increased by 2-3%. Wages would have declined while mortgage, car, and loan payments stayed the same. That is a receipt for a disaster. We would have experienced drastic increases in household and bank defaults.

As much as Republicans want to change the mandate of the Federal Reserve, it would not change how they have conducted policy. Inflation rates are well below their target of 2-3%. Greg Mankiw, a conservative economics has also voiced his opinion on the matter:

I am skeptical. If the Fed's mandate were different, monetary policy today might well be the same. That is, with inflation now below its target, the Fed could be pursuing QE2 even if it were operating under the proposed mono mandate. Looking ahead, the Fed believes that inflation too low, even deflation, is a larger risk than inflation too high, so it is engaging in expansionary policy to get inflation back on target.

My view is that QE2 is a modestly good idea. I say it is a "good idea" because, like Ben Bernanke, I am more worried at the moment about Japanese-style deflation and stagnation than I am about excessive inflation. By lowering long-term real interest rates below where they otherwise would be, QE2 should help expand aggregate demand. I include the modifier "modestly" because I don't expect these actions to have a very large effect.

I think Congress is looking for someone else to blame instead of focusing on their own problems. Instead of blaming the Federal Reserve for doing something, perhaps they should focus on using fiscal policy to improve the economy. They need to be finding way to increase spending, cut taxes today and reducing the national debt over the next ten years. Going after the Fed tells me they are trying to avoid more pressing issues.

Well this is not good news. The unemployment rate has increased to 9.8% for November. The economy added 39,000 which is below the expected 150,000 jobs that were forecasted. Part of the increase is from discouraged workers reentering the labor force. The labor force increased by 100,000 workers, but the number of unemployed increased by 250,000.

Wednesday, December 1, 2010

I tend to disagree is Krugman on structural unemployment. He views the current increase in unemployment as entirely cyclical (in his mind the economy has a natural rate around 5%), while I view the increase in unemployment as increases in structural and cyclical (in my mind the economy has a natural unemployment rate around 6.5-7%). Krugman goes on to say:

As far as I can tell, the only economists who believe that we’re suffering largely from a rise in structural unemployment are those who are ideologically committed to the view that the demand side of the economy doesn’t matter — and so by definition, in their universe, any large rise in unemployment must be structural.

Well, I believe the demand side does matter and we have an increase in structural unemployment. The difference between Krugman and myself is where we see potential output, mainly during the housing boom. Krugman's argument implicitly assumes the economy was operating at potential output during the housing boom. I believe the economy was operating slightly above potential during the same time period. In other word, the 5% unemployment in the economy was because cyclical unemployment was negative. If you go back to 2000, you'll see large decreases in the manufacturing employment. This is the exact definition of structural unemployment. These workers do not have the skills needed to find employment in the current economy. During the housing bubble, the construction industry was clearly operating above it's potential) took on the unemployed manufacturing workers. Today employment in the construction industry has returned to pre-bubble levels, and we're left with 8 million unemployed manufacturing workers.

In economic jargon, the supply curve of labor was flat but is now sloping upward, so that rapidly increasing demand for labor resulting from rapid growth is driving up wages. That means that China is beginning to “rejoin the human race” as capital accumulation meets scarcer labor and growth slows.

No, well yes, okay maybe. It depends are you a buyer or a seller. Housing prices declined by 2% during the third quarter, but for most of 2009 and 2010 have remained stable. I expect this is be part of the new normal. Housing prices should increase at the same rate as inflation (1-2% annually). A lot of the price changes will have to do with the interest rates. With low interest rates, I'm surprised prices didn't increase a little, but with a fixed population there is no reason to expect housing prices will increase at a faster rate, unless we end up in another housing bubble.